International Trade
Commerce Among Nations
Foreign exchange is, in a sense, a certain kind of international trade - institutions from various countries buying and selling currencies from each other. It therefore shouldn’t come as a surprise that the market for different forms of money often overlap with the international market for goods and services as a whole. In this article, we’re going to explore the nuances of international trade and the various measurements used to track capital flows in and out of countries.
The Balance of Payments
The fundamental metric used by economists studying international trade is the balance of payments (BoP). We mentioned this in our article on foreign exchange reserves, but just to recap, the BoP represents all transactions made between countries over a defined period. It tracks the imports and exports of goods, services, capital, and transfer payments (i.e. foreign aid). The BoP can be divided into 2 components:
Current account: the imports and exports of goods & services, investment fees paid and received abroad, and transfer payments
Capital account: deals with the capital flowing in and out of a country, often taking the form of foreign investments and changes in foreign exchange reserves
The 2 segments work inversely; if the US exports an item that’s worth $100 to China, that’s $100 added to America’s current account transactions, since the trade involves the exporting of goods. At the same time however, America is also importing $100 in cash from China who’s paying for the export. As such, $100 is then removed from America’s capital account but added to China’s.
The opposite situation works similarly: if the US imports a $100 item from China, they are effectively exporting $100 in cash to pay for that item. Thus, $100 is subtracted from America’s current account and $100 is added to their capital account. On China’s end, $100 is added to their current account (since that’s the value of the item being exported) and $100 is subtracted from their capital account (since that’s the value of the money coming into the country).
The key principle here is that exports - in the form of either goods/services or money - add to the country’s current/capital account (depending on whether goods/services or money is being exported). Imports subtract from the country’s current/capital account, again depending on whether goods/services or money is being imported. And since these kinds of transactions must necessarily include both - that is, the importation and exportation of goods/services and money from the trading countries - the current/capital account surpluses and deficits cancel each other out and arrive at an equilibrium.
Current Account
Going into this measurement a bit deeper, we find that it’s made up of 4 segments: goods & services (pretty self explanatory), foreign income (when a domestic entity receives money from a foreign entity), and transfer payments. These factors are all put into an equation like so:
CA: the current account
X: exports
M: imports
NY: net income from abroad
NCT: current net transfers
Seeing as how the exports and imports are the largest part of the current account, it’s very possible for a country to end up in a current account deficit, wherein a country imported more goods, services, and capital than it exported. This can be caused by numerous factors; the business cycle, for example, can determine how wide a current account deficit may be or if there even is one to begin with. During strong economic expansions, imports tend to increase as business activity expands, but that doesn’t mean exports will be able to keep up. If they don’t, the current account deficit will widen. On the other hand, because recessions are characterized by a decrease in business activity and thus a decrease in imports, the current account deficit will also shrink.
Foreign exchange rates can also exert influence over a country’s current account balance. A highly-valued currency means cheaper imports (since a single unit of the currency can be exchanged for more units of another country’s currency and therefore, that other country’s goods), and cheaper imports mean more imports which in turn widen the deficit. A more expensive currency also decreases exports because residents of other countries will have to spend a lot of their money for a lot less when buying from the exporting country. Conversely, a cheaper currency makes imports more expensive (and exports cheaper), thus decreasing imports (and/or increasing exports) and narrowing the deficit.
The question from here, of course, is what actions can be taken to close the current account deficit, or in other words, how to increase exports and/or decrease imports. There are 2 general approaches to this: the first is implementing restrictions on imports (tariffs, quotas, etc) and/or promoting exports (subsidies, expanding credit, etc). The second is via adjusting foreign exchange rates such that exports for foreign consumers become cheaper (selling the country’s currency on the open market, increasing its supply and thereby decreasing its value), which can sometimes escalate into currency wars, wherein countries will deliberately devalue their currencies in order to maintain a competitive edge in exports with other nations.
Capital Account
Before breaking down the capital account into its 4 classifications of the flow of money, it’s important to first look at the 2 subaccounts. The first is non-produced & non-financial assets, consisting of tangible assets (land, oil, buildings, etc) as well as intangible assets (intellectual property, franchise rights, etc). The second is capital transfers, which include insurance payments, debt forgiveness, and the transfer of the US government’s assets in the Panama Canal (a waterway that serves as an important shortcut for ships traveling between the Atlantic and Pacific oceans).
At a rather superficial level, the capital account really comprises only changes in foreign ownership of domestic assets and changes in domestic ownerships of foreign assets. But the metric can be broken down into more detail like so
Foreign direct investment: long-term capital investment, such as the construction of a factory. If foreigners invest in a country, that counts as a surplus item on the capital account whereas if a country’s citizens are investing in foreign countries, that counts as a deficit. Profits made from these investments, however, are counted into the current account
Portfolio investment: the purchasing of shares and bonds (securities that investors add to their investment portfolios). Similar to foreign direct investments, any returns from these assets are counted into the current account
Other investment: either capital flows into bank accounts or loans being given out
Reserve account: put simply, this is a change in a central bank’s foreign reserves, that is, the money that flows in and out of the country as a result of the buying or selling of foreign currencies by the central bank. The reserve account is a crucially large part of the capital account, so much so that there’s a whole debate as to whether it should even be included. China's capital account, excluding the reserve account, had a large surplus in the early 21st century. But if we include the reserve account, China's capital account was in large deficit, as the People’s Bank of China purchased large amounts of foreign assets
Financial Account
Although not listed as part of the balance of payments as most people understand it, it can nevertheless be confused with the capital account and it is therefore important to clear up the terms here.
The capital account records transfers of capital assets between countries, whereas the financial account tracks the ownerships of international assets. Like the capital account, there are 2 main subaccounts to the financial account: the first deals with the domestic ownership of foreign assets and the second deals with foreign ownership of domestic assets. Now this part may sound familiar as it is what we referred to as the “superficial definition of the capital account.” The reason for this overlap is because the IMF, OECD and United Nations System of National Accounts (SNA) use their own definition of the BoP accounts. Their interpretation has 3 main accounts: the current and capital account plus the financial account, which entails transactions that would have otherwise been recorded under the capital account.
If there’s an increase in US-owned foreign assets or a decrease in foreign-owned assets in the US, the US’s financial account is decreased. Contrarily, if there’s a decrease in US-owned foreign assets abroad or an increase in foreign-owned assets in the US, the financial account increases.
Econ IRL
When a city experiences strong wage growth, where do these gains go: to the individuals who grew up near said city or do the gains instead distribute throughout the surrounding area? Another way of framing the question would be do people migrate substantial distances from their childhood home when they hear of new economic opportunity? This week’s paper answers both questions by first analyzing statistics on migration between patterns between childhood and young adulthood. Therein lies the first observation: most young adults don’t move far from home, with ⅔ of them still living in their childhood area at age 26. 80% move less than 100 miles.
But how do these migration decisions play out in response to changing labor market conditions? The problem with this question is that it’s difficult to single-out the nature of, say, a city’s wage increase. Maybe wages rose in a given city because a bunch of high-income people moved there. In other words, how do we know that the wage changes are the result of changes in the demand for labor rather than some other factors?
The researchers develop a testing mechanism for this potential variable and, after confirming that the variation in wages is driven primarily by demand shocks, they then find a causal effect of wage opportunities on migration. Even though there are very clear effects of wage changes on migration, said effects are small. In fact, most beneficiaries of local wage growth aren’t even people who migrated far to get a piece of the action - the majority of those individuals were lucky enough to grow up in nearby locations.
‘Till next time,
SoBasically